Federal Income Tax Passive Activity Losses Tax

Rental Losses for Real Estate Agents

Is a real estate agent a real estate professional? This is an important question if the real estate agent also owns rental real estate that throws off tax losses. The answer dictates whether real estate agents are able to deduct rental losses against non-rental income. The court addresses this question in Agarwal v. Commissioner, T.C. Summary Opinion 2009-29. The case is a must-read for anyone in a real estate-related business who own loss producing rental properties.

Facts & Procedural History

This case concerned the taxpayer-wife’s job. She was licensed as a real estate agent. She was employed as a realtor by Century 21. As are most realtors, she was paid as a contractor.

The taxpayers also owned two rental properties. The taxpayer-wife managed the properties.

In 2001 and 2002, the taxpayer-wife reported approx. $13K of income from selling homes. She also reported about that much in expenses. This resulted in a small loss each year.

The taxpayers reported a $20K and $40K loss in these years for their rental properties. The losses were deducted and offset the taxpayer-husband’s employee wages.

The IRS audited their tax returns and disallowed the losses. It did so by asserting that the passive activity loss rules (“PAL rules”) applied. According to the IRS, the taxpayer-wife did not qualify for the “real estate professional” exception to the PAL rules. The taxpayers eventually litigated the case in the U.S. Tax Court.

This case presents the very fundamental question as to whether a realtor who has minimal income, and perhaps minimal work activity as a relator, can qualify as a real estate professional.

About the Passive Activity Loss Rules

The PAL rules were enacted in the late 1980s to limit the ability for taxpayers to use rental real estate to reduce income taxes.

Readers that are older will recall that the tax rates were extraordinarily high in the 1980s. Those with higher incomes had a strong incentive to find ways to lower their tax burden.

Many turned to real estate given the ability to generate tax losses. They did so by borrowing money and buying real estate using other people’s money. This allowed the investor to obtain a sizable amount of real estate with little money down–and to do so while maintaining the investor’s full-time day job. From a tax perspective, this entitled the investor to significant depreciation deductions, interest deductions, etc.

The PAL rules are very nuanced, but not all that difficult to plan for and avoid. One way to avoid the rules is to qualify as a “real estate professional.”

The Real Estate Professional Exception

The real estate professional exception is set out in the Code. It essentially treats rental real estate as any other trade or business in which the taxpayer materially participates. These non-real estate businesses are able to generate tax deductions that can offset other items of income, such as employee wages.

To qualify, the taxpayer generally has to show that they spend at least half of their working hours on real estate and over 750 hours in real estate.

For the hours that are counted, the hours spent in certain real estate related professions can count. These businesses are referred to as a “real property trade or business.”

The Code defines a “real property trade or business” as:

any real property development, redevelopment, construction, reconstruction, acquisition, conversion, rental, operation, management, leasing, or brokerage trade or business.

If the taxpayer’s non-rental activities fall into these categories, then the hours spent on these activities can be counted in determining whether the taxpayer spent half of their time in real estate and whether it was more than 750 hours during the year.

This allows many taxpayers to qualify as real estate professionals and, thereby, deduct rental property losses against their other business income.

Is a Realtor a Real Estate Professional?

That brings us to the Agarwal case. In Agarwal, the IRS argued that the taxpayer-wife was a real estate agent, not a real estate broker.

As set out in the quote above, the “real property trade or business” language only includes brokerage businesses. It does not list real estate agents as qualifying.

This was the IRS’s argument. It argued that absent a broker’s license, the taxpayer-wife could not be a real estate professional.

The court did not agree with the IRS. The court did not look to the state licensing rules. Rather, the court looked to the ordinary definition of the term “real estate brokerage” as it is commonly understood. This definition includes real estate sales. Based on this, the court concluded that the taxpayer-wife is a real estate professional. The court allowed the taxpayers to offset the taxpayer-husband’s wages with the losses from their rental properties.

Tax Planning for Real Estate Professionals

This case makes it clear that real estate agents qualify as real estate professionals. If they own rental real estate, they will almost always be able to use the losses from the rental properties to offset their income.

While not addressed in the case, there is an exception for employee wages. Employee wages in these businesses do not count unless the taxpayer owns 5 percent or more of the business.

For example, if the taxpayer-wife worked as an employee of a real estate property management business, her wages from the property management business could not be counted. The wages could be counted if she owned more than 5% of the property management business.

It should also be noted that taxpayers may be required to group their rental and non-rental activities by making an election to do so. The grouping rules create other complexities that have to be considered, which warrants talking with an experienced tax attorney.

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